Estate planning is critical to avoid passing down major tax burdens to your beneficiaries. The good news is that the IRS does offer some tax breaks when it comes to the transfer of assets, known as step-up in basis rules.
In this article, we’ll cover the basics of step-up basis rules, including when they apply, how they work, and the main differences between separate property states and community property states. Understanding the specifics of basis rules can be confusing.
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What is a Step Up in Basis?
When it comes to estate taxation, assets fall into two main categories: “Income in Respect of a Decedent” and assets that are subject to a step up in basis. Income in Respect of a Decedent assets, known as IRD, includes final paychecks, Traditional IRAs, 401(k)s, and unrealized net appreciation. These assets don’t receive favorable tax treatment and are instead subject to general taxation when they are distributed to each beneficiary.
On the contrary, assets that aren’t considered IRD are considered eligible for a step up in basis. Common assets include real estate and general investment accounts that hold stocks, bonds, ETFs, and other digital assets. Many of these assets will have unrealized gains when the account holder leaves Earth. Step-up in basis rules allow the cost basis to be adjusted to the fair market value on the date of death rather than the original date of purchase.
For example, an individual purchased 3 shares of stock for $150. Thanks to market appreciation, these same 3 shares are now worth $250 on the date of death. Instead of paying $100 in capital gains tax on the market appreciation when the beneficiary sells the shares, they will only pay taxes on appreciation above $250.
Step Up in Basis Rules to Be Aware Of
Step up in basis rules can quickly become complex. First, there is a one-year holding period that can limit your eligibility to use the step-up in basis rules. Under IRC Section 1014(e), if assets pass back to the original donor within one year of the gift, there is no step-up in basis. This rule is designed to prohibit a family from gifting assets to someone who is about to pass away.
Let’s illustrate this concept with an example. Suppose that Joe and Mary hold an investment account with a fair market value of $500,000. The account is in Mary’s name only, and the original cost basis of the stock was $100,000. Joe receives a terminally ill diagnosis.
Mary decides to transfer ownership of the investment account to Joe. If Joe were to pass away within one year of the transfer date, there would be no step-up in basis. However, if Joe were to pass away two years after the transfer, Mary would be able to use the $500,000 fair market value as her new cost basis.
Furthermore, it’s important to note that a step up in basis only applies to assets included in the decedent’s estate at the time of death. This rule is especially important when it comes to establishing irrevocable trusts. Let’s say that Jerry established an irrevocable trust that contains ownership in a few different corporations. His daughter, Jessy, is the recipient.
Jerry passes away, which triggers the irrevocable trust’s ownership transfer to Jessy. Since the irrevocable trust is not considered a party of Jerry’s estate, Jessy will not receive a step-up in basis and will need to use the original cost basis when determining income taxes.
Differences Between Separate Property States and Community Property States
When you get married, the most common method of managing finances is to open joint accounts. Although this can make day-to-day transactions easier, it’s not always the best method when it comes to estate taxes, especially if you reside in a separate property state. For one, IRC Section 2040 outlines that when spouses have a “Qualified Joint Interest,” they are presumed to have 50/50 ownership of the account. This means that when one spouse passes away, only 50% of the assets will receive step up in basis treatment.
Let’s go through an example to demonstrate the tax implications of separate property states. Sam and Kelly own 10% of ABC, Inc. and live in a separate property state. They purchased shares in the company for $30,000 nearly 10 years ago. ABC, Inc. experienced rapid growth, and their 10% stake is now valued at $150,000. Kelly passed away. Under separate property state regulations, Sam’s new basis in ABC, Inc. is $90,000 instead of the fair market value of $150,000. This is because Kelly’s estate only includes half of the ownership.
Community property states have different regulations for applying step up basis rules. In community property states, joint property consists of assets acquired during the marriage. These assets are considered 100% owned by each spouse, regardless of how it’s titled. This treatment is favorable because each spouse is eligible for a full step up in basis.
Going back to our previous example with Sam and Kelly, let’s now say they lived in a community property state. Even if the shares of ABC, Inc. were under Sam’s name, he would receive a full step up in basis to $150,000 following Kelly’s death. If the shares of ABC, Inc. continued to grow in value to $250,000 upon Sam’s death, the beneficiaries would receive another step up in basis.
Do you feel overwhelmed yet? If so, don’t worry. Here’s a five-step process to get you started:
1. Evaluate Your Accounts – Which accounts and investments will qualify for a step up in basis?
2. Know Your State – Do you live in a separate property state or a community property state?
3. Determine Your Options – What can you do to minimize your estate taxes?
4. Think of the Future – Remember, if you are transferring ownership to minimize taxes, you no longer have control over those assets. The recipient of the transfer has legal ownership and can change how these assets are distributed upon your death.
5. Talk to an Expert – You most likely don’t have all the answers. It’s important to find an expert that can help you walk through the specifics of basis rules and how you can fully leverage the benefits.
IRS. About Publication 551, Basis of Assets. IRS, 2 June 2023, https://www.irs.gov/forms-pubs/about-publication-551. Accessed 15 Dec 2023.
Legal Information Institute. “26 U.S. Code § 1014 - Basis of property acquired from a decedent.” Legal Information Institute, 2023, https://www.law.cornell.edu/uscode/text/26/1014. Accessed 15 Dec 2023.
Legal Information Institute. “26 U.S. Code § 2040 - Joint interests.” Legal Information Institute, 2023, https://www.law.cornell.edu/uscode/text/26/2040. Accessed 15 Dec 2023.
Tax Foundation. “Step-Up In Basis.” Tax Foundation, 2023, https://taxfoundation.org/taxedu/glossary/step-up-in-basis/. Accessed 15 Dec 2023.